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Gold Matters (published in October of 2010 in the SB News Press)

We have witnessed one of the strongest rallies in gold (and commodities in general), in history. Gold is currently trading around $1,325 per ounce, off about 4.5% from its recent all-time high of $1,388 per ounce, which it hit earlier this month. The rally from the most recent significant low of $1,036, which was set in July of 2009, represents a 34% gain in a little more than a year.

Gold has historically been a store of value and a hedge against inflation. While this still holds true, more recently we have seen gold rally on fears of deflation as well (although the pull-back over the past few weeks shows a break in this trend). What is the significance of the rally in gold and what lessons can we learn from it?

Many point to President Nixon’s decision to take the U.S. off of the gold standard in 1971 as the beginning of the modern Federal Reserve. One the gold standard was abandoned, the Fed could influence the economy much more directly through open market operations and rate changes.

The Bretton Woods Agreements established the system under which countries fixed their exchange rates relative to the U.S. dollar. The U.S. promised to fix the price of gold at $35 per ounce, which in essence pegged these countries’ currencies to the dollar, which meant that their currencies also had a fixed value in terms of gold. Under the regime of the French President Charles de Gaulle up to 1970, France reduced its dollar reserves, trading them for gold from the U.S. government, thereby reducing U.S. economic influence abroad. This, along with the fiscal strain of federal expenditures for the Vietnam War, led President Nixon to end the direct convertibility of the dollar to gold in 1971, resulting in the system’s breakdown, commonly known as the Nixon Shock.

Debate still rages as to whether Nixon made the right decision. I would say that one could argue about the timing, but the reality is that, sooner or later, we were going to be forced to drop the gold standard. The U.S. economy is far too large and complex, and the world economy even more so, to rely on the value of gold or any other single store of value.

Over the past five years, gold has basically doubled in value. If we think back over all of the different economic changes we have experienced, from boom and busts in real estate and stocks, the financial market implosion and partial rebound, and the world economic recession, it is interesting that gold has made such an impressive run. We did have a significant pull-back from around $1,050 in mid-2008 (remember when oil collapsed), down to about $750, but gold quickly recaptured the $1,000 mark about six months later.

So why should we care about gold? Gold is not only an investment option, and many strategists would argue that is should be a part of every portfolio, but it is also the best hedge against inflation. But, like any investment vehicle, the price can make gold unattractive and risky to purchase. We have seen a huge run-up in the price of gold, as stated above, so is this the time to buy it—will it continue to rally, or should investors wait for lower prices before adding gold to portfolios?

The answer is not a simple one—there are many economic and political factors that affect the price of gold. Also, the reality is that gold is not so much driven by economics and politics, as by those speculating and investing in it, and those making a living from the trading in gold. Since the financial market collapse in late 2008, commodities brokers have had a compelling story to tell about the importance of owning gold, and they have taken full advantage of it. One could argue, based on the fact that these brokers all over the world have been pounding the table on gold for so long, that we are in a bubble, which could burst at any time.

While it is my feeling that gold is in a bubble, and as a result there is significant downside risk in owning gold, I feel there are powerful reasons to expect gold to continue to rally for some time. With this stated, the higher the price goes, the more likely there will be corrections of increasing magnitudes, making buying and owning gold increasingly more risky.

What the rally in gold is telling us is that we should expect inflation in the near future. This makes complete sense, because the Fed has dropped rates to zero, and the government has been pumping hundreds of billions of dollars into the economy through borrowing. Our national debt is the highest in history, and is around $13 trillion. We have a massive annual budget deficit, so we are forced to sell new bonds to finance the interest on the national debt and the shortfall on the budget. Luckily at present, rates are historically low (the 10-year treasury is yielding just 2.57%), which means that the cost of servicing the national debt is relatively low. However, at some point in the near future, when the economy starts to heat up, the Fed will be forced to raise rates to combat inflation, and the cost of servicing our debt will rise dramatically.

The implication for an inflated price of gold in a rising interest rate environment is that gold would get hit quite hard, especially if the price continues to rise from current levels. Increasing interest rates not only cool inflation, but they strengthen the value of the dollar over time, which is also negative for the price of gold.

For local investors who own real estate, owning gold is a more complicated still. Real estate historically has been a decent hedge against inflation as well, although the current real estate market is suffering from much more powerful and direct influences than inflation. While I do not expect real estate prices to increase (due to inflation or for any other reason) for many years, a long-term investor with a significant portion of their total net worth invested in real estate would want to consider a gold investment in the context of the total portfolio, and the possible, long-term impact of inflation on their real estate holdings, (even if that real estate “investment” is the family home).

My personal feeling on gold is that it will likely rally some more from current levels, possibly after a short-term correction of $100 per ounce or so. Each investor should consider their personal risk tolerance and investment objectives before considering an investment in gold, and for most investors gold (if included in portfolios at all), should be a small percentage of the total value of the portfolio. While it is not a bad idea in a very general sense, for gold to be in portfolios, one must be aware of the current and relative value of gold in the big picture context of the sustained rally it has experienced and the risk inherent in it at these levels.

If those who continue to recommend buying gold are correct, and if the current price of gold is an indication of inflation to come, we should all be prepared for the impact of significant inflation on interest rates, the economy, employment, and businesses. Higher rates make it more difficult for companies that need to refinance existing debts or to borrow new money to afford the cost of the interest. Higher costs for businesses mean that they have less money to hire people, develop new products, advertise, expand into new markets, etc. Local companies should plan ahead, locking in financing at today’s attractive rates, if possible, with longer-term maturities, so that enough funding is available for their long-term strategic plans.

Hopefully the Fed will be able to raise rates enough to combat inflation without crushing the economy. Personally, I think the coming few years will be the most challenging for the Fed in its entire history. I just hope they are up to the challenge.

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